contribute to your 401k or pay off loans first? Forum

[tengorazon]

Thanks. I think Ill buy a couple of the suggested books in that link. Any other good books not mentioned in that first sticky aimed toward beginners?

"The Elements of Investing" by Malkiel and Ellis is a good, short read. Frankly though, as someone familiar with online message boards, you can learn pretty much all you need to know just by browsing through the current and old threads on Bogleheads. Start with the Help with Personal Investments subforum. There, people will post their current financial portraits and long-time members will provide advice on proper asset allocation. People also tend to ask basic questions there. If you're confused about a topic, search for old threads or post your question. You can spend weeks taking in old info. From there, move on to the Theory, News, & General subforum. They tend to discuss more advanced topics. Noted personal finance authors Larry Swedroe and Rick Ferri often post there.

For a biglawyer, these are probably the most important topics:

1. Bond allocation (most bogleheads recommend age in bonds, but it really depends on your risk tolerance...I'm at about 10%).

2. International allocation (typical recommendation is 20-50%; I hold international at market weight, so about 52%).

3. Taxes. 401(k)'s (if your wife is a teacher, 403(b) is probably the equivalent for her) and IRAs are tax-advantaged accounts. There are Roth options for both (i.e., pay taxes up-front and nothing when you withdraw), but a Roth 401(k) generally doesn't make sense for someone in a biglawyer's tax bracket. There are many ways to lower your tax burden in retirement. By contrast, there are only a few ways to lower your high marginal tax rate while working. You will make too much money to benefit from a traditional IRA, so a back-door Roth IRA will be your only other option for tax-advantaged space until you have kids and start contributing to 529s. Once you have maxed out your tax-advantaged space (and there is really no reason not to max that out), you start saving in taxable space. Even there, there are ways to minimize your tax burden (e.g., tax loss harvesting, donating appreciated shares to charity, stacking property tax payments). But at your future income level, don't expect many tax breaks.

[Fark-o-vision]

dingbat, my 401(k) has made 9% this year. jelly?

Also, as I said earlier, the money you put in a 401(k) will compound interest for decades, whereas the 6.8%-7.8% that you pay on a loan 1) doesn't compound and 2) only lasts for as long as the loan exists (maximum of 25 years thanks to my main man Obama). In the long run, you're far better off investing in the 401(k). Obviously, having some liquid savings built up is recommended for emergencies, and you should still put as much as you can toward your student loans, but if you're in biglaw there's no excuse to not max out your 401(k) contribution.

Your analysis also depends heavily on the uncertainty of future tax rates, which IMO shouldn't be considered since it's so unpredictable. You'd have to pay the taxes today if you didn't invest in a 401(k).

Dingbat shouldn't blast for fail when committing fail. Difference of simple interest vs. compound interest still makes student loan the cheapest money you can get your hands on, usually (please don't rip with simple and obvious examples, like 0% car loan. It embarrasses all of us). meanwhile, the compounding factor of your 401(K) makes it a great long-term vehicle. Even if you want to play it safe and just keep pace with inflation, at least you have the money when you need it.

[tengorazon]

You're forgetting that you will need to pay tax when the money comes out of the 401(k)*

. . . .

*the key factor is, you know what your tax rate is today, but god knows what your tax rate is when you take the money out

You can really only make tax decisions based on current information. Today, there are many ways to reduce your tax burden in retirement (e.g., carried forward losses). And there's no reason to think that Congress won't continue to cater to the olds. By contrast, the number of tax breaks for those currently in the high tax brackets is very small and set to become even smaller.

[dingbat]

Difference of simple interest vs. compound interest still makes student loan the cheapest money you can get your hands on, usually (please don't rip with simple and obvious examples, like 0% car loan. It embarrasses all of us). meanwhile, the compounding factor of your 401(K) makes it a great long-term vehicle. Even if you want to play it safe and just keep pace with inflation, at least you have the money when you need it.

Maybe you think 6.8% is cheap. My current borrowing rate is significantly lower
If you think that the loan being simple means that it's better to leave that with a high balance and stick it into a 401k that compounds, it means you have no idea how loan amortization works.

Time for some simple math. Let's assume the 401(k) earns the same 6.8% (annualized rate) as the student loan.

Student Loan $100,000
10 years
Monthly Payment: $1,151 ($1,535 pretax)
Total payments: $138,096

Now, let's say you have $1,000 per month that you can either put into a 401(K) or use to pay down the loan. Let's assume a 25% tax rate

Option A) repay the loan
Monthly Payment$ 1,901
Time: 5 years, 3 months (2.65, but we'll round accordingly)
Total payments: $119,078
Savings: $19,018.
Now we put the full remaining balance into the 401K ($1,000 plus $1,535 pretax)
Balance at the end of 10 years: $171,210 (4 years and 9 months)

Option B) 401K
Monthly payment $1,000
Balance at the end of 10 years: $171,193

So, by putting it into the 401(k) you're more or less breaking even.
Except that while the interest rate on your student loan doesn't fluctuate, there are no guarantees on the investments in your 401(k)

If, like InGoodFaith, you can get returns in excess of 6.8%, you're better off.
If you can't, you're better off paying your loans off first.
Caveat: at least for the next few years, we can reasonably foresee a low interest rate environment. If you take risks (and invest well), you can get higher returns, but that is not typical.

[20130312]

But for some reason, you're only looking at TEN YEARS on the 401(k). Extend that out to 30 and you'll get a much different answer. This is why you shouldn't touch the money in your 401(k).

[fatduck]

But for some reason, you're only looking at TEN YEARS on the 401(k). Extend that out to 30 and you'll get a much different answer. This is why you shouldn't touch the money in your 401(k).

in his example the 401(k) balance after 10 years is the same in both scenarios (and the loan is paid off), so...shouldn't it be the same after 30?

[dingbat]

But for some reason, you're only looking at TEN YEARS on the 401(k). Extend that out to 30 and you'll get a much different answer. This is why you shouldn't touch the money in your 401(k).

No, considering that both scenarios end up with more or less the same amount of cash in the 401(k) at the end of the 10 year period, going beyond that is meaningless (extrapolating to a further date assuming the same investment and additional payments would result in the same end result: $508,458 vs $508,492 after 20 years)

Basically, my calculations proved that, assuming the same return on investment as the interest rate on the loan, and assuming the same total amount is set aside, either to pay off the loan or to put into a 401(k), if there is no change in tax rate and no other factors, then the end result is the same. The above difference is presumably a rounding issue
So, it really comes down to whether or not your 401(k) can outperform the cost of your loans
(and if there's a cap on contributions)

edit: scooped

But for some reason, you're only looking at TEN YEARS on the 401(k). Extend that out to 30 and you'll get a much different answer. This is why you shouldn't touch the money in your 401(k).

in his example the 401(k) balance after 10 years is the same in both scenarios (and the loan is paid off), so...shouldn't it be the same after 30?

[dingbat]

You're forgetting that you will need to pay tax when the money comes out of the 401(k)*

. . . .

*the key factor is, you know what your tax rate is today, but god knows what your tax rate is when you take the money out

You can really only make tax decisions based on current information. Today, there are many ways to reduce your tax burden in retirement (e.g., carried forward losses). And there's no reason to think that Congress won't continue to cater to the olds. By contrast, the number of tax breaks for those currently in the high tax brackets is very small and set to become even smaller.

Actually, at my now ex-job, when projecting far into the future we always assumed taxes will be higher, at least for the top brackets.
and before anyone thinks this might be unique to our firm, we've worked with and/or discussed our projects with the top wealth management firms

[ToTransferOrNot]

You're forgetting that you will need to pay tax when the money comes out of the 401(k)*

. . . .

*the key factor is, you know what your tax rate is today, but god knows what your tax rate is when you take the money out

You can really only make tax decisions based on current information. Today, there are many ways to reduce your tax burden in retirement (e.g., carried forward losses). And there's no reason to think that Congress won't continue to cater to the olds. By contrast, the number of tax breaks for those currently in the high tax brackets is very small and set to become even smaller.

Actually, at my now ex-job, when projecting far into the future we always assumed taxes will be higher, at least for the top brackets.
and before anyone thinks this might be unique to our firm, we've worked with and/or discussed our projects with the top wealth management firms

IS there some product that is basically a tax rate swap? I'd love to place massive bets on the idea that tax rates will be higher in the future than they are now.

[dingbat]

IS there some product that is basically a tax rate swap? I'd love to place massive bets on the idea that tax rates will be higher in the future than they are now.

Not as you described, however, there are some alternatives, but talk to a tax advisor first:

An IRA/Roth IRA is effectively a swap (Traditional IRA assumes taxes will be lower in the future, Roth IRA negates future higher taxes)
Municipal bonds are tax exempt, so if tax rates go up, the value of municipal bonds should go up as well
Political Risk swaps may serve a similar function, but I don't know enough about these to be say for sure
Variable/Universal life insurance should never be purchased for the purpose of avoiding taxes, but can minimize tax liability as part of an estate plan

Disclaimer: nothing in this post should be considered tax advice, nor should any part of this post be used or relied upon to avoid taxes. Seriously. I do not give tax advice nor should anything I say be construed as tax advice. Talk to an accountant.

[Brassica7]

Absolutely max out your 401k first. Remember: in a 401(k), interest compounds. Student loans are simple interest. So you will be FAR better off in the long run contributing to the 401(k).

I believe this is not correct. The interest will compound against you for the loan, just as interest compounds in your favor on investments. Also, if you have the un-subsidized loans, the interest rate that you avoid if you pay them early is 7.9%. Effectively, if you pay off $10,000 worth of loans ahead of schedule, you "earn" whatever the interest rate on the loans was, compounding each year. Finally, this is tax free, risk free investment. I believe paying off the loans first is the better choice.

I have been reading more of the above posts...does the interest on our loan really not compound? If so, then scratch what I wrote above.

[dingbat]

Absolutely max out your 401k first. Remember: in a 401(k), interest compounds. Student loans are simple interest. So you will be FAR better off in the long run contributing to the 401(k).

I believe this is not correct. The interest will compound against you for the loan, just as interest compounds in your favor on investments. Also, if you have the un-subsidized loans, the interest rate that you avoid if you pay them early is 7.9%. Effectively, if you pay off $10,000 worth of loans ahead of schedule, you "earn" whatever the interest rate on the loans was, compounding each year. Finally, this is tax free, risk free investment. I believe paying off the loans first is the better choice.

You are correct. Unfortunately, a little information can do a lot of harm, and people think they know what they're talking about merely by googling a few terms.

[Tiago Splitter]

Love the 401k loan idea, but keep in mind that many plans don't allow for loans. Also, the Roth 401k works well as a sort of emergency fund if Lathamed. Can't hurt to make part of the 17K Roth if the plan allows for it.

[20130312]

Absolutely max out your 401k first. Remember: in a 401(k), interest compounds. Student loans are simple interest. So you will be FAR better off in the long run contributing to the 401(k).

I believe this is not correct. The interest will compound against you for the loan, just as interest compounds in your favor on investments. Also, if you have the un-subsidized loans, the interest rate that you avoid if you pay them early is 7.9%. Effectively, if you pay off $10,000 worth of loans ahead of schedule, you "earn" whatever the interest rate on the loans was, compounding each year. Finally, this is tax free, risk free investment. I believe paying off the loans first is the better choice.

You are correct. Unfortunately, a little information can do a lot of harm, and people think they know what they're talking about merely by googling a few terms.

Ouch.

[emkay625]

Additionally, I want to caution against assuming a return from a 401K is a sure thing. I chose to sink as much money as possible into my 401K instead of developing an emergency fund when I first started working. I first started working in January of 2008. We all know what happened 10 months later.

I lost a shit ton of money.

[emkay625]

Finally, OP, I have 2 book recommendations:

http://www.amazon.com/Journal-Complete- ... al+finance

http://www.amazon.com/Generation-Earn-P ... fessionals

[Aqualibrium]

I plan on reading this thread--and checking out some of the books and websites mentioned in it--more closely at some point, but for now I have this question:

I don't know a damn thing about personal finance beyond how to balance my checkbook, and I'm happier when my vanguard account balance is higher than it was last time I checked rather than lower (I store chunks of money in a fund I have there whenever I get a chance and just let my self forget it exists). I have no student loans, no mortgage, and have paid off my 3 year old car in full. I never plan o buying a house. All those things considered, should I max my 401k or just contribute what the firm is willing to match?

[emkay625]

I plan on reading this thread--and checking out some of the books and websites mentioned in it--more closely at some point, but for now I have this question:

I don't know a damn thing about personal finance beyond how to balance my checkbook, and I'm happier when my vanguard account balance is higher than it was last time I checked rather than lower (I store chunks of money in a fund I have there whenever I get a chance and just let my self forget it exists). I have no student loans, no mortgage, and have paid off my 3 year old car in full. I never plan o buying a house. All those things considered, should I max my 401k or just contribute what the firm is willing to match?

If you have no debt and are not planning on acquiring any more, I would sink all that I could into the 401K plus put a little aside each month to have in a normal savings account. I say this because if you DO for some reason get laid off/fired, it can take a few weeks sometimes (depending on your plan) to get money out of your 401K, and you don't want to be stuck in limbo with no access to money for 2 weeks. Plus you'll want that basic savings account for things like vacations, saving up so you can buy your next car with cash, etc.

[emkay625]

I plan on reading this thread--and checking out some of the books and websites mentioned in it--more closely at some point, but for now I have this question:

I don't know a damn thing about personal finance beyond how to balance my checkbook, and I'm happier when my vanguard account balance is higher than it was last time I checked rather than lower (I store chunks of money in a fund I have there whenever I get a chance and just let my self forget it exists). I have no student loans, no mortgage, and have paid off my 3 year old car in full. I never plan o buying a house. All those things considered, should I max my 401k or just contribute what the firm is willing to match?

ALSO you want to look at how that 401K is structured. Is it all in stocks? How much choice do you have?

[tengorazon]

I plan on reading this thread--and checking out some of the books and websites mentioned in it--more closely at some point, but for now I have this question:

I don't know a damn thing about personal finance beyond how to balance my checkbook, and I'm happier when my vanguard account balance is higher than it was last time I checked rather than lower (I store chunks of money in a fund I have there whenever I get a chance and just let my self forget it exists). I have no student loans, no mortgage, and have paid off my 3 year old car in full. I never plan o buying a house. All those things considered, should I max my 401k or just contribute what the firm is willing to match?

Good for you for starting early and for choosing Vanguard. You should absolutely max it out, if for no other reason than the tax advantages. Of course, it would be even better if your 401(k) had some good, low-cost options, but even if it doesn't, you're almost assuredly better off maxing it out. Then I'd do a back-door Roth IRA as I described earlier. And on top of that, I'd invest in a regular taxable account. Not really a reason you can't do all of that if you're making biglaw money and have no loans or mortgage.

[dingbat]

Ouch.

Sorry, not aimed at you personally. But it's true

[dingbat]

I plan on reading this thread--and checking out some of the books and websites mentioned in it--more closely at some point, but for now I have this question:

I don't know a damn thing about personal finance beyond how to balance my checkbook, and I'm happier when my vanguard account balance is higher than it was last time I checked rather than lower (I store chunks of money in a fund I have there whenever I get a chance and just let my self forget it exists). I have no student loans, no mortgage, and have paid off my 3 year old car in full. I never plan o buying a house. All those things considered, should I max my 401k or just contribute what the firm is willing to match?

Good for you for starting early and for choosing Vanguard. You should absolutely max it out, if for no other reason than the tax advantages. Of course, it would be even better if your 401(k) had some good, low-cost options, but even if it doesn't, you're almost assuredly better off maxing it out. Then I'd do a back-door Roth IRA as I described earlier. And on top of that, I'd invest in a regular taxable account. Not really a reason you can't do all of that if you're making biglaw money and have no loans or mortgage.

Bonus points to you.
You might want to do a little research into all the available options (e.g. Roth IRA vs Traditional IRA).
Also remember to rebalance your portfolio every once in a while
(let's say you decide to invest $50 in bond funds and $50 in stock funds. A few years later, the bonds have grown to $60, but the stocks are now $80; then you should trade in $10 stocks for bonds, to maintain an even split)

[Anonymous User]

My loans are at 2.99% (long story). I have approximately 200k in loans, but a big law job and a clerkship bonus this year. How much should I be paying towards my loans? I don't know much about IRAs and stuff like that (tho this thread has been very informative).

[20130312]

My loans are at 2.99% (long story). I have approximately 200k in loans, but a big law job and a clerkship bonus this year. How much should I be paying towards my loans? I don't know much about IRAs and stuff like that (tho this thread has been very informative).

Is it a variable rate loan? If it's fixed at 3%, I wouldn't pay a dime more than I had to each month because your 401(k) (or IRA if you prefer) will CERTAINLY give you a rate of return better than 3% in the long run. But dingbat will give you a more technical analysis. Take it away ding!

[Anonymous User]

I'm the poster with the 2.99% loans. I believe the rate is fixed for three or five years, and then it's variable (and even when the rate becomes variable, there is a limit to how much they can increase the interest rate every year).